Saturday, December 11, 2010

Securities and Futures Associations Ask the SEC and CFTC to Extend Comment Periods on Proposed Regulations Implementing Dodd-Frank Derivatives Regime

While recognizing that the Dodd-Frank Act imposes short and strict deadlines on the SEC and CFTC to adopt regulations implementing the legislation’s derivatives provisions, and commending the agencies for diligence with regard to this unprecedented endeavor, securities and futures trade associations have asked the SEC and CFTC to extend the comment period of the rule proposals so that a more coordinated response can be crafted. In a letter to the SEC and CFTC, the Futures Industry Association, SIFMA, the Investment Company Institute and others are also concerned about a process that provides for provisional registration of entities prior to adoption of final rules defining the various categories of registrants and establishing their respective obligations. A more logical sequence would first adopt definitions for the different regulated entities, then requirements for such entities, and finally registration of such entities. The letter was also signed by ISDA, the American Bankers Association, and the Managed Funds Association.

With regard to the comment period, the sequence and the timing of the various proposals have left the securities and futures industry in something of a quandary. The order in which rules are being published for comment makes it difficult for many firms to know whether they should submit comments on particular rules, and also to determine what the substance and extent of their comments should be. For example, on November 10, 2010, the CFTC proposed rules on six different topics, including conflicts of interest, chief compliance officers, and registration of swap dealers and major swap participants. In each case, these rules might raise significant issues for swap dealers and swap participants, said the letter, but not be particularly significant for other entities.

The trade associations view the timing of these proposals as problematic because the Commissions have only recently in earley December addressed the terms “swap dealer” and “major swap participant” in proposed regulations. Without guidance as to the scope of these definitions, some firms are uncertain whether they should comment on the rules that apply to swap dealers and major swap participants because they did not know whether these rules would apply to them.

Preparing comment letters requires significant time and expense, explained the groups, and firms are reluctant to incur the cost of commenting unnecessarily. To give all possibly affected parties an opportunity to comment on relevant proposed rules, the groups asked the CFTC and SEC to extend the comment deadlines for proposals that utilize terms that were not defined when the rules were published so that those comment deadlines are at least no earlier than the deadlines applicable to the rules defining the terms.

More substantively, the trade groups are also concerned that market participants will be asked to do too much in too short a time. The application of Dodd-Frank’s clearing and execution provisions across the full or a broad range of different types of swaps within a relatively short period would likely impose a compliance burden with which market participants, and in particular dealers, simply could not comply. Further, mandating the implementation of reporting requirements in the same short period as implementation of clearing and execution requirements increases the likelihood that market participants will be unable to comply. Their only alternative would be to stop entering into the transactions for which compliance is not immediately possible, thus leaving segments of the market with diminished or possibly no liquidity.

The groups fear that this could have significant adverse consequences for the customers that rely on these products and it would be inconsistent with the risk reduction goals of Dodd-Frank. To implement a complex new regulatory structure without adequate time to adapt and test systems also could lead to an ineffective or poorly designed reporting, clearing, and exchange infrastructure, cautioned the groups, which also would impair liquidity and increase risk.

Implementing clearing and execution requirements without thoroughly analyzing the ability of particular asset classes to absorb the changes carries a number of other risks as well. Clearing, for example, is an extraordinarily complex undertaking that requires significant adaptation to existing technology systems and legal arrangements between parties. As new clearinghouses proliferate and compete, noted the letter, the early-mover advantage may entice some clearinghouses to start clearing products before they are truly ready from an operational standpoint. Similar problems are likely to arise with trade execution requirements, where liquidity considerations should play a primary role in driving implementation timeframes. In all of these instances, premature imposition of new rules can, and likely will, lead to increased risks for markets and market participants.

The trade groups pointed out that Dodd-Frank gives the SEC and CFTC discretion in determining when new regulatory measures will become applicable. For example, sections 754 and 774 of Dodd-Frank provides that the provisions of Title VII covering the regulation of swaps markets and security-based swap markets require that rulemaking must take effect not less than 60 days after publication of the final regulation. According to the groups, this language reflects an understanding that regulated entities need sufficient time to comply, it but also means that they can be given more time.

The associations asked the SEC and CFTC to use their discretion in this manner where appropriate, including situations where the demands placed upon regulated entities would make it impossible or impractical for them to comply in accordance with the most restrictive time limits provided in the legislation. The SEC and CFTC were urged to take into account the practical realities facing market participants and to phase-in the application of new regulatory requirements over a reasonable period of time, determined through discussions with the market participants directly affected by those requirements.

The FIA and SIFMA hopefully noted that the CFTC has demonstrated its willingness to use its regulatory discretion under Dodd-Frank to address impossible or impractical requirements. For example, in establishing the effective date for interim reporting of pre-enactment swaps, the CFTC noted that, although the legislation imposed reporting requirements that became effective upon enactment, there are no registered data repositories to accept the data, nor is the CFTC ready to accept it. Thus, the CFTC provided in its interim final rule that the obligation to report such transactions would not become effective until the compliance date for reporting under section 2(h)(5) of the Commodity Exchange Act or “within 60 days after a swap data repository becomes registered . . . and commences operations to receive and maintain data related to such swap, whichever occurs first.”

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